Volatility in equity and other financial markets hit us again over the summer and may continue for some time. In this article, we have a look at the consequences of this volatility for pension plans and consider both short- and long-term actions in response. The economic background is under discussion continually – but if we are to plan for anything, it would seem to be for “continual uncertainty,” and perhaps for not quite as good a medium-term outlook as we thought. Half of economists polled now appear to be forecasting a double-dip recession and, in the UK, a prize has been offered for a solution to the conundrum of how a country might exit the euro! Equity markets don’t like uncertainty and this is undoubtedly a reason for the recent volatility; however, if growth does stall significantly, the prospects for a sustained bounceback look challenging.

Concurrent with the equity market volatility, bond markets are being priced at close to all-time low yields. For both defined benefit (DB) and defined contribution plans, this is double bad news – because buying an annuity or a pension becomes more costly at the same time that assets are falling. What is also worrying is the sheer scale of deficits, as lower bond yields lead to a higher assessment of the liability values for corporate pension plan sponsors. Take a look at the aggregate of the S&P1500 companies in the US in the chart below:

S&P 1500 Funded Status

The size of the combined plan deficits (around 72% funded on the chart) is estimated to be around $500 billion (again), a similar level to that reached during August 2010. At the end of September, total liabilities for S&P 1500 companies are estimated at around $1.9 trillion, with assets estimated at $1.4 trillion.

In other countries in which DB liabilities are prevalent, the picture is very similar. This deficit situation is all too familiar and in a previous article we summarized various country positions (see Global Pension Risk Strategy, November 2010). 

Enterprise risk

Before delving into solutions for removing volatility in funded status, it is important to bring a business perspective to the picture, particularly in the current challenging environment. Companies have very different operational and financial models that can lead to a range of approaches to enterprise risk management strategies. However, with the ever-increasing importance of pension deficits, it’s important to correctly assess the pension risk in the context of the existing business risks. For example, how does the pension plan risk compare to the long-term debt profile or capital requirements? What would be the impact on profits and the pension deficit in an inflationary environment? How important would the potential pension problem look in this context – is there additional capacity to bear this risk?

Scenarios

When looking at volatility, a typical 1 in 20 VaR analysis is only an overall indicator. Clearly, lower interest rates – at long durations – and poor equity returns are bad for DB plans, but it also helps to understand the existing position taken relative to today’s market environment. Is there a chance of higher interest rates appearing soon? Will inflation stay high?

We are in a debt crisis, with governments and consumers highly leveraged. In the absence of strong growth to bail us out, part of the resolution will need to be increased savings or government taxation over time. Such a backdrop may be challenging for equity market valuations over time. Interest rates could also remain low for some time, as the Federal Reserve and other government agencies in the developed world have few other options and still have the power to extend their actions in this area.

An interesting factor to consider is inflation. The outcome here is also highly uncertain. While inflation is often cited as a key solution to reducing the debt problem – as it would allow the fixed debt to become less significant against the real economy – it is not clear how this will affect pension deficits. For example, while most inflationary scenarios would act to reduce liability valuations for US plans, this may not be true for non-US plans, whose benefits tend to be inflation-linked. At the same time, an inflationary scenario may not be good for asset valuations if equity markets struggle under an environment in which costs are rising faster than revenues.  

Overall, the economic outlook gives us no clear picture of how future volatility may affect deficit levels, and the appropriate action should be to prepare for a range of potential future outcomes.

Actions

First, do the first things. You first need to review what you expect your funding and accounting numbers will look like at the year end and then work through the immediate effects on the company and its key financial ratios. There may be requirements for additional or increased cash contributions and/or knock-on effects for other business initiatives. You may also need to ensure that the potential for increased deficit disclosures at year end will not adversely affect any loan covenant restrictions or credit-rating measures. It would also be worthwhile to open discussions with advisers on any accounting or funding policy changes that could be enacted at year end to help reduce projected costs.

Cash effects may vary significantly, depending on the timing of country requirements and whether you are hitting any trigger levels. In the US, for example, funding levels under 60% can trigger a cessation of benefit accrual. Also, any plans in place for a lump-sum cash-out exercise in 2012 will likely require the plan to be funded at or above 80% levels on a PPA basis and will therefore be affected by the progress of corporate bond yields. The timing of this risk-transfer objective may need revisiting in light of the increased levels of deficits. In other countries, similar issues may need review – for example, lower rates may lead UK trustees to reconsider the levels of individual transfer payments or any larger-scale transfer-value exercise.

It is important to reconsider your risk roadmap and ensure that it is tailored to the requirements of your own near-term and longer-term business planning needs. There may be details to advance or delay in the investment approach, such as rebalancing to achieve better diversification or increasing allocations to longer-dated bonds to manage risk. Perhaps it’s not the time to move further with creating locally appropriate glide paths, moving toward lower-risk strategies over time. But now, more than ever, it is important to establish a clear direction of travel in managing the dynamic nature of risk exposures. Of course, the ultimate challenge remains to avoid taking action at inopportune investment levels as well as managing longer-term cost expectations, but it is not wise to leave it to chance. For multinationals, a global decision is required on the local risk capacity, and this needs to be aligned with local and global business plans.

As noted above, interest rate risk has been the dominant factor recently, notwithstanding the poor equity markets. So it becomes more imperative to manage the duration and interest rate risk of the liabilities (and their nature, in terms of inflation linkage). As a side note for those who have already embraced a de-risking strategy of some kind, our experience is that plans that have made the move to long-duration strategies have suffered only about half the funding level declines as other plans.

Furthermore, with the sustained fall in interest rates, ongoing accrual costs are still on the rise. In this environment, plan design is back on the radar and careful analysis will be needed to understand the range of options and the employment consequences of seeking to freeze or cease accrual of DB benefits.  

However, it’s not all bad news, as those companies with borrowing capacity can take advantage of the low rates by “borrowing to fund” the pension deficit while de-risking assets. 

The long view

This is not a time to temporize. It’s a time to be proactive about pension risk and to ensure that contingency plans are in place.

• Don’t be overexposed to one scenario but ensure that there is protection against a range of potential outcomes.

• Be mindful about building internal consensus in the organization for any planned changes – a typical de-risking program design can take up to 12 months or more to get approval before implementation can proceed.